Failing Up: The Fraud of the Green and Sustainability-Linked Bond Market

For those who aren’t familiar with the term, greenwashing is the act of making investments which only superficially appear to fit a sustainability mandate. By doing so, a manager may have many clients who don’t notice that they have a number of irresponsible issuers in their portfolios.

But portfolios of green and sustainability-linked bonds are fine, right? Unfortunately, it’s not that easy. Portfolios that rely on such labels may be the most greenwashed of them all. Why? Because the decision as to what constitutes a green or sustainability-linked bond is mostly left to the capital markets process.

This is where Philip Morris International hopes to fit in. Philip Morris International (PMI), the non-US manufacturer and distributor of the Marlboro cigarette brand, announced in August 2021 that it would be issuing an ESG bond. Yes, you read that right.1 They have no business issuing ESG bonds, and managers who claim to offer ESG strategies have no business buying these “business transformation” bonds. Issuers like PMI will seek to opportunistically raise capital with the lowest cost and fewest restrictions possible. The financial sector’s socially responsible bonds are a prime example of this. Many banks issue bonds which are marketed as requiring them to use the proceeds to provide services to underserved communities. But a careful reading of the language in the indentures show that they simply “aim to” use a like amount of capital. There is no earmarking or restriction on the capital raised, and without the ability to verify or be held accountable, there are no real consequences. We discuss this more later; suffice it to say here that a commitment without consequences is at best a promise and most likely just a marketing ploy.

The banks have what some consider a valid argument for creating this loophole: Restricted capital cannot get the same regulatory liquidity credit as unrestricted capital. However, just as with Phillip Morris International, this response caters to optics. The truth is that not every issuer can or should be allowed to participate in markets which are intended to fund ESG progress if that issuer cannot make a sincere and enforceable commitment. Sometimes, the best way to contribute to progress is to recognize that we are not the star in every story, show some empathy and just get out of the way. These issuers would be well-served to learn this lesson: This market is not about you.

Which begs the question: Why would serious investors allow opportunistic issuers to undermine the credibility of the entire green and sustainability-linked bond market? They probably wouldn’t, but the ecosystem of intermediaries they hire doesn’t share their sincerity. Bankers who are paid by issuers only push back on issuers when they are forced to do so by fund managers. And herein lies the insidious truth about green and sustainability-linked bonds. Many managers have made a good living by convincing investors that they are fighting the good fight. They point to consequences built into green and sustainability-linked bonds. In some structures, if a company doesn’t meet certain targets, coupons can increase; in others, coupons may decrease upon reaching certain goals. Many managers will wax eloquent about their quest to make sure these targets are sufficiently meaningful and represent true progress. If they are too easy to meet, then the consequences have no teeth, they argue.

But the problem here isn’t in the targets companies must meet. It is in the incentives of the managers. If they are being evaluated by the outside world based on performance, they will seek the highest total return available within their universe. If that universe is green and sustainability-linked bonds, marketed in an ESG strategy to investors, the highest total return comes when companies miss their targets. If a portfolio contains bonds most likely to miss their targets, it will generate a higher total return than one in which coupons are lowered or not raised because the company was successful in its ESG goals. Investors should not be so naïve as to believe the managers aren’t fully aware of this loophole.2

Notwithstanding the fact that the broader investment manager community probably would prefer this not to change, we are compelled to ask the obvious question: How could this be improved? The answer can be found in none other than the very bond documents that govern the green and sustainability-linked bonds (and all bonds for that matter). In all bond indentures, companies are required to meet certain covenants. In many cases, especially as the covenants pertain to financial metrics such as leverage, free cash flow and additional debt incurrence, a failure to adhere to the covenant triggers an event of default. The point of these types of technical defaults (distinguished from a default caused by a failure to pay interest or repay principal) is to give investors the opportunity to accelerate the repayment of their principal early enough to minimize or possibly entirely avoid any principal loss. When this happens, the company must raise additional capital, offer concessions or accept a loss of access to capital markets. If a company is too impaired, the investor will lose money.

The key characteristic in these default triggers is existential risk. The company’s existence is at risk. The investors stand to lose principal if they remain invested in companies who are likely to trip a covenant. Since most green and sustainability-linked bonds are issued by investment grade companies, and since the consequences of failing to meet a target are typical small adjustments of a coupon (+0.25% per annum is not atypical), there is no existential risk to the company. Further, there is not only no real principal risk to investors; they actually win. The circumstances set up in these types of bonds is cheap to fail for the issuers and beneficial to fail for the managers.

A more aligned ecosystem would be one in which ESG triggers were set up as covenants, accelerating repayment of debt if a company fails to meet them. This would result in ESG factors impacting credit ratings, which would finally force the credit markets to face the reality that ESG factors are credit factors. Until then, we must call green and sustainability-linked bonds what they are: cynical ploys that enable the Wall Street capital markets machine, which includes fund managers, to market ESG without actually aligning performance with progress. This won’t always be the case, but it is today. And if ESG factors are not part of the credit process at the issuer level, there is little hope that a portfolio with these misaligned incentives at the issue level will accomplish its goals.

We caution even the slightest ESG-interested investor to avoid such strategies, less-rigorous and rooted in marketing, where managers hope that no one will notice (or care) that they have to catch up with rigor when the markets require it. At Zeo, we prefer to be prepared with a diligent and consistent process from the start. Our approach is not a fit for everyone, but it is sincere and we believe more likely to deliver consistent results with fewer surprises over the long term.


By Venk Reddy
Originally published in Q3 2021 letter

1 You can read more on the topic in our commentary, “Trust Us, We’re Kool: A Cautionary Tale for ESG Investors Who Actually Care.”

2 There is a counterargument worth sharing here. It is true that the executives of a company which doesn’t live up to its commitments lose credibility, and possibly, their jobs. Therefore, regardless of manager incentives, it may still be in the best interest of the issuer’s management team to meet its targets, in which case, increasingly difficult goals may have some opportunity for impact. However, our issue here is not with the effort to hold companies accountable to meet objectives that demonstrate legitimate progress. Our issue is with a market ecosystem making the case that, in order to make sure that happens, investment managers will act contrary to their own incentives and interests, for possibly the first time in the history of the financial services industry. Yeah, sure.

Important Disclosure Information

Zeo Capital Advisors is a fundamental investment manager with a short-duration credit mutual fund, a sustainable high yield mutual fund and separately managed accounts. Venk Reddy authored this piece and is the Chief Investment Officer and founded Zeo Capital Advisors in 2009.

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